Proposed regs would modify nondiscrimination requirements for certain retirement plans
Proposed regs would modify nondiscrimination requirements for certain retirement plans
Preamble to Prop Reg 1/28/2016; Prop Reg § 1.401(a)(4)-2, Prop Reg § 1.401(a)(4)-3, Prop Reg § 1.401(a)(4)-4, Prop Reg § 1.401(a)(4)-8, Prop Reg § 1.401(a)(4)-9 , Prop Reg § 1.401(a)(4)-12 , Prop Reg § 1.401(a)(4)-13
IRS has issued proposed regs that would modify the nondiscrimination requirements applicable to certain retirement plans that provide additional benefits to a grandfathered group of employees following certain changes in the coverage of a defined benefit plan or a defined benefit plan formula. The proposed regs would also make certain other changes to the nondiscrimination rules that are not limited to these plans. The proposed regs would generally be effective upon finalization, but certain provisions can be applied to plan years beginning after Jan. 1, 2014.
Background. In general, under Code Sec. 401(a)(4), a plan is a qualified plan only if the contributions or benefits provided under the plan do not discriminate in favor of highly compensated employees (HCEs). Regs issued under Code Sec. 401(a)(4) (originally issued in ’91, amended in ’93) provide several alternative methods for testing compliance with this requirement.
Under Reg. § 1.401(a)(4)-1(b)(2), a plan is permitted to demonstrate that either the contributions or the benefits provided under the plan are nondiscriminatory in amount, regardless of whether the plan is a defined benefit (DB) or defined contribution (DC) plan (referred to as “cross-testing”). In order to test a DC plan on the basis of benefits, the amounts allocated to employees under the plan must be converted to equivalent benefits using an interest rate between 7.5% and 8.5%. In addition, for purposes of Code Sec. 401(a)(4), a DB plan and a DC plan are permitted to be aggregated and treated as a single plan (a DB/DC plan) pursuant to Reg. § 1.401(a)(4)-9.
After the final regs were issued, a new type of plan design developed that is often referred to as a “new comparability” plan. This plan is typically a DC plan that provides higher allocation rates to an older and more highly compensated group of employees, but nonetheless satisfied the nondiscrimination requirements by testing the contributions on the basis of equivalent benefits, where the way the conversion is calculated resulted in relatively lower equivalent benefits for the HCEs because they were closer to normal retirement age. IRS found this type of plan inconsistent with the intent behind the nondiscrimination regs and amended them in 2001 to require that a new comparability plan provide a higher minimum contribution to non-HCEs in order for the plan to satisfy Code Sec. 401(a)(4) on the basis of equivalent benefits (see Weekly Alert ¶ 3 7/12/2001).
This higher minimum contribution requirement in the 2001 amendments was directed at the new comparability plans. Other DC plans that provide “broadly available allocation rates” or allocation rates that are “based on a gradual age or service schedule” are not subject to the higher minimum contribution requirement even if they demonstrate compliance with the nondiscrimination requirements of Code Sec. 401(a)(4) on the basis of equivalent benefits. Also under the 2001 amendments, defined benefit replacement allocations (DBRAs) may be disregarded when determining whether a DC plan has broadly available allocation rates. The 2001 amendments also prescribe rules regarding DB/DC plans that provide for benefits in a manner similar to new comparability plans, including a rule that, in order for a DB/DC plan to be eligible to demonstrate compliance with Code Sec. 401(a)(4) on the basis of equivalent benefits, it must satisfy a minimum aggregate allocation gateway unless the DB/DC plan either fits within the definition of “primarily defined benefit in character” or consists of “broadly available separate plans.”
Since 2001, a number of employers have moved away from providing retirement benefits through traditional DB plans. In many of these cases, employers have either significantly changed the type of benefit formula provided under the plan (such as in the case of a conversion to a cash balance plan), or have prohibited new employees from entering the plan entirely. The employers may then have allowed employees who had already begun participation in the DB plan (or who are older or have been credited with longer service under the plan) to continue to earn pension benefits under the DB plan while closing the plan or formula to all other employees. These DB plans are sometimes referred to as “closed plans,” and the employees who continue to earn pension benefits under the closed plan are often known as a “grandfathered group of employees.” In situations in which new employees continue to earn benefits under the DB plan, but are under a new formula, any formula that continues to apply to a grandfathered group of employees is sometimes referred to as a “closed formula.”
Closed plans are required to meet the coverage rules under Code Sec. 410(b) and the nondiscrimination rules under Code Sec. 401(a)(4), including a nondiscrimination requirement regarding the availability of benefits, rights, and features. Many closed plans, however, may eventually find it difficult to meet these requirements because the proportion of the grandfathered group of employees who are HCEs compared to the employer’s total workforce increases over time—i.e., members of the grandfathered group of employees usually continue to receive pay raises and become HCEs, and new employees (who are generally non-HCEs) are not covered by the closed plan. When a closed DB plan can no longer meet the nondiscrimination requirements on a stand-alone basis because of these demographic changes, it can demonstrate compliance with Code Sec. 401(a)(4) by aggregating with the employer’s DC plan.
In 2014, IRS issued Notice 2014-5, 2014-2 IRB 276, which provided temporary nondiscrimination relief for certain closed plans (see Weekly Alert ¶ 34 12/19/2013). Specifically, under Notice 2014-5, if certain criteria are satisfied, a plan sponsor is permitted to test a DB/DC plan that includes a closed plan that was closed before Dec. 13, 2013, on a benefits basis for plan years beginning before Jan. 1, 2016, without complying with the minimum aggregate allocation gateway.Notice 2015-28, 2015-14 IRB 848 extended that relief for an additional year (see Weekly Alert ¶ 20 3/26/2015).
New guidance. IRS now wants to make permanent changes to the nondiscrimination rules in order to help employers and plan sponsors preserve the retirement expectations of certain grandfathered groups of employees. These changes are meant to apply to situations in which the proportion of the grandfathered group of employees who are HCEs compared to the employer’s total workforce has increased due to ordinary demographic changes.
The proposed regs would modify a number of provisions in the existing Code Sec. 401(a)(4) regs to address situations and plan designs, including closed plans and formulas, that were not contemplated when the existing final regs were issued (and amended).
First, the proposed regs would establish special rules that allow closed plans and similar arrangements to satisfy the nondiscrimination rules in additional situations. The existing rules for DBRAs would be modified, would allow more allocations to fit within the DBRA rules, and would provide more flexibility in making such an allocation. The proposed regs would also expand the list of permitted amendments to a closed plan that would not prevent allocations under a plan from being DBRAs, and incorporate a modified version of the conditions for an allocation to be a DBRA that were reflected in Rev Rul 2001-30, 2001-2 CB 46 (Weekly Alert ¶ 3 7/12/2001). The proposed regs would also retain the exception from this restriction on plan amendments for an amendment that makes de minimis changes in the calculation of a DBRA. (Prop Reg § 1.401(a)-8)
The proposed regs would also add a new exception to the requirement that a DB/DC plan must satisfy the minimum aggregate allocation gateway when certain other conditions under Reg. § 1.401(a)(4)-9 are not met (the “closed plan rule”). This closed plan rule, which would apply to a DB/DC plan that includes a closed plan, would provide an exception to the minimum aggregate allocation gateway that would otherwise apply, but only if the closed plan was in effect for five years before the closure date and no significant change was made to the closed plan during or since that time (except for certain permitted amendments). Certain amendments to a closed DB plan—namely, those intended to allow a plan sponsor of a closed plan to address changed circumstances—would not prevent the plan from using the closed plan rule. (Prop Reg § 1.401(a)-9(b)(2)(v)(F))
The proposed regs would establish a special nondiscrimination testing rule that would apply if a benefit, right, or feature is made available only to a grandfathered group of employees with respect to a closed plan. (Prop Reg § 1.401(a)(4)-4(d)(8)) This special rule would provide relief in certain circumstances from certain nondiscrimination testing for a benefit, right, or feature provided under the closed plan, or for a rate of matching contributions provided to a grandfathered group under a DC plan. If the eligibility conditions are satisfied, the special testing rule would treat a benefit, right, or feature that is provided only to a grandfathered group of employees as satisfying the current and effective availability tests in Reg. § 1.401(a)(4)-4. (Prop Reg § 1.401(a)(4)-4(d)(8)(ii))
In addition to providing a special rule for closed plans and similar arrangements, the proposed regs would generally ease the rules under which any DB/DC plan can satisfy the nondiscrimination-in-amount requirement. These changes are intended to facilitate the ongoing maintenance of a DB plan that provides coverage to a group of employees that is determined using a reasonable business classification. Specifically, the proposed regs would expand the ability to use the average of the equivalent allocation rates under the DB plan, for purposes of satisfying the minimum aggregate allocation gateway, by permitting the averaging of allocation rates for non-HCEs under the DC plan for this purpose in order to better accommodate plan sponsors that have a DC plan with service or age-based allocation formulas. (Prop Reg § 1.401(a)(4)-9(b)(3)) The proposed regs would also include a limitation on the averaging of rates that applies to both DC and DB plans in order to minimize the impact of “outliers,” provide that the average of the matching contributions actually made for non-HCEs may be used to a limited extent for purposes of determining whether each non-HCE satisfies the minimum aggregate allocation gateway test, and provide a new alternative to the minimum aggregate allocation gateway.
Finally, the proposed regs would include changes to address certain arrangements that take advantage of the flexibility in the existing nondiscrimination rules to provide a special benefit formula for selected employees, but don’t extend that formula to a classification of employees that is reasonable and is established under objective business criteria, by limiting the existing rule under which a rate group with respect to an HCE is treated as satisfying the average benefit percentage test to those situations in which the allocation formula (or benefit formula) that applies to the HCE also applies to a reasonable business classification. (Prop Reg § 1.401(a)(4)-3)
Effective date. The proposed regs would generally apply to plan years beginning on or after the date they are published as final. However, taxpayers may apply certain provisions for plan years beginning on or after Jan. 1, 2014, and until the final regs apply—namely, the disregard of certain DBRAs in cross-testing; the exception from the minimum aggregate allocation gateway with respect to certain closed plans; the special testing rule for benefits, rights, and features with respect to certain closed plans; and the rule applying the ratio percentage test to a rate group in the case of a benefit formula that does not apply to a reasonable business classification. (Prop Reg § 1.401(a)(4)-13)
References: For qualified plan nondiscrimination rules, see FTC 2d/FIN ¶ H-6100 et seq.; United States Tax Reporter ¶ 4014.14; TaxDesk ¶ 286,010; TG ¶ 8083.